Fixed vs. Adjustable

A fixed-rate mortgage charges a set rate of interest that does not change throughout the life of the loan. Although the amount of principal and interest paid each month varies from payment to payment, the total payment remains the same, which makes budgeting easy for homeowners.

The partial amortization schedule below demonstrates the way in which the principal and interest payments vary over the life of the mortgage. In this example, the mortgage term is 30 years, the principal is $100,000 and the interest rate is 6%.

As you can see, the payments made during the initial years of a mortgage consist primarily of interest payments.

The main advantage of a fixed-rate loan is that the borrower is protected from sudden and potentially significant increases in monthly mortgage payments if interest rates rise. Fixed-rate mortgages are easy to understand and vary from lender to lender in respect to rate and costs.

Although the rate of interest is fixed, the total amount of interest you’ll pay depends on the mortgage term. Traditional lending institutions offer fixed-rate mortgages in a variety of terms, the most common of which are 30, 20, 15 and 10 years.

The 30-year mortgage is the most popular choice because it offers the lowest monthly payment; however, the trade-off for that low payment is a significantly higher overall cost because the extra decade, or more, in the term is devoted primarily to paying interest. The monthly payments for shorter-term mortgages are higher so that the principal is repaid in a shorter time frame. Also, shorter-term mortgages offer a lower interest rate, which allows for a larger amount of principal repaid with each mortgage payment, so shorter-term mortgages cost significantly less overall.

The interest rate for an adjustable-rate mortgage varies over time. The initial interest rate on an ARM is set below the market rate on a comparable fixed-rate loan, and then the rate rises as time goes on. If the ARM is held long enough, the interest rate likely will surpass the going rate for fixed-rate loans.

ARMs have a fixed period of time during which the initial interest rate remains constant, after which the interest rate adjusts at a pre-arranged frequency. The fixed-rate period can vary significantly – anywhere from one month to 10 years. Shorter adjustment periods generally carry lower initial interest rates.

ARM Terminology

ARMS are significantly more complicated than fixed-rate loans, so exploring the pros and cons requires an understanding of some basic terminology. Here are some concepts borrowers need to know before selecting an ARM.

• Adjustment Frequency – This refers to the amount of time between interest-rate adjustments (e.g. monthly, yearly, etc.).
• Adjustment Indexes – Interest-rate adjustments are tied to a specific index, or benchmark, such as the interest rate on certificates of deposit or Treasury bills, or the LIBOR rate.
• Margin – When you sign your loan, you agree to pay a rate that is a certain percentage higher than the adjustment index. For example, your adjustable rate may be the rate of the one-year T-bill plus 2%. That extra 2% is called the margin.
• Caps – This refers to the limit on the amount the interest rate can increase each adjustment period. Some ARMs also offer caps on the total monthly payment.
• Ceiling – This is the highest interest rate that the adjustable rate is permitted to become during the life of the loan.

ARMs are attractive because they offer low initial payments, enable the borrower to qualify for a larger loan and in a falling interest rate environment, allow the borrower to enjoy lower interest rates (and lower mortgage payments) without the need to refinance. The ARM, however, can pose some significant downsides. With an ARM, your monthly payment may change frequently over the life of the loan. And if you take on a large loan, you could be in trouble when interest rates.

An ARM may be an excellent choice if low payments in the near term are your primary requirement or if you don’t plan to live in the property long enough for the rates to rise. If interest rates are high and expected to fall, an ARM will ensure that you enjoy lower interest rates without the need to refinance. If interest rates are climbing or a steady, predictable payment is important to you, a fixed-rate mortgage may be the way to go.

Regardless of the loan that you select, choosing carefully will help you avoid costly mistakes.